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Covered Interest Arbitrage

7. Covered Interest Arbitrage (CIA)

7. Covered Interest Arbitrage (CIA)

Given the following:

US 90-day interest rate 5%
Canadian 90-day interest rate 10%
Current Spot Rate $0.8512/C$
90-day Forward Rate $0.8501/C$

You have $1 Million and would like to engage in CIA:

i.) Outline the steps for CIA with the appropriate computation there of and compute the profit.

ii) Compute the Return on Investment of $1 million and identify its components:

a) Interest Rate Component and
b) Exchange Gain/Loss Component

iii) For Interest Rate Parity to prevail, what should be the forward rate of the C$?

Solution Preview

7. Covered Interest Arbitrage (CIA)

Given the following:

US 90-day interest rate 5%
Canadian 90-day interest rate 10%
Current Spot Rate $0.8512/C$
90-day Forward Rate $0.8501/C$

You have $1 Million and would like to engage in CIA:

i.) Outline the steps for CIA with the appropriate computation there of and compute the profit.

ii) Compute the Return on Investment of $1 million and identify its components:

a) Interest Rate Component and
b) Exchange Gain/Loss Component

iii) For Interest Rate Parity to prevail, what should be the forward rate of the C$?

iii) For Interest Rate Parity to prevail, what should be the forward rate of the C$?

For interest rate parity to prevail
Forward rate / Spot rate = (1+ US interest rate x 90/365) / (1+ Canadian interest rate x 90/365)

or Forward rate / $ 0.8512 = (1+ 5% x 90/365) / (1+ 10% x 90/365)

or Forward rate = $0.8410 /C$

i.) Outline the steps ...

Solution Summary

Illustrates the mechanism of Covered Interest Arbitrage.

$2.19